Why the Fall in IPOs Is a Threat to Popular Capitalism

In 1996, at the start of the dot-com boom, the number of initial
public offerings (IPOs) in the United States reached 677. This
marked the peak of new share offerings on American exchanges. It
seems particularly fitting that, at the end of that year,
then-Federal Reserve chairman Alan Greenspan would warn of
“irrational exuberance… unduly escalat[ing] asset values.”

To expect a return to the heady IPO days of the late 1990s may
be unrealistic, perhaps even mistaken, given the recession that
followed them. But since the turn of the millennium, and
particularly in the wake of the 2008 crash, the pace of new share
issues has slowed to a crawl.

It is tempting to blame the slowdown on a post-recessionary
hangover and a tepid recovery. Typically, periods of negative
growth - especially those contemporaneous with bank failures and
financial instability - are followed by some years of limited
business creation and expansion. Furthermore, investors wary of
recent losses might require rates of return beyond what listing
firms can offer.

But there are reasons to doubt whether this story applies to our
recent experience. Indeed, if anything, capital markets suffer from
an embarrassment of riches. Investable funds are in plentiful
supply. Global private pension assets amounted to $41.4 trillion in
2017. That’s 2.3 times the size of the US economy. Chinese people
and companies save 46 per cent of the country’s GDP, even as the
latter continues to grow at high rates. According to Credit Suisse,
more than half of the world’s $280 trillion aggregate wealth is in
financial assets.

Higher barriers to entry
into public markets not only raise the cost of capital for small
firms, but they also foreclose investment opportunities for
ordinary investors.

Bond yields, a measure of the return demanded by investors,
remain relatively low, even if much is made of rates on US 10-year
notes recently reaching 3 per cent. Price-earnings ratios on big
American listed firms remain above 20, considered expensive by
historical standards. The mood of investors, in other words, is
closer to measured confidence than cautious retreat.

If the problem isn’t capital supply, could it be that demand is
absent? The rate of business “churn” - that is, the amount of
annual entry and exit - has declined since the 1980s. To the extent
that reflects a reduction in dynamism, it could have pushed down
business demand for capital.

However, this narrative has some problems. Firm churn began its
decline long before the advent of the IPO drought. Additionally,
funds specialising in new and struggling firms have recently had
some of their best years. In 2017, venture capital firms invested a
record $148 billion. Private equity funds raised $453 billion.

Plainly, startup and growing firms are looking elsewhere than
the public markets for capital. And who could blame them? Issuing
shares to the public is expensive. Underwriters charge four to
seven per cent of the value of the sale in fees. Together with
other costs, an initial public offering (IPO) can set a firm back
tens of millions of dollars. That’s not even the end of it:
remaining public costs the average firm $1.5 million, according to
PWC.

Much of the cost of a public issue relates to regulatory burden.
After the accounting scandals of the early 2000s, American
legislators passed the Sarbanes-Oxley Act, which introduced new
governance, accounting and disclosure requirements for public
firms. Latterly, the Securities and Exchange Commission (SEC) has
promulgated regulations aimed at increasing market efficiency and
liquidity. But a side-effect of this rule-making activity has been
to make trading in small-capitalisation firms less profitable.

Higher barriers to entry into public markets not only raise the
cost of capital for small firms, but they also foreclose investment
opportunities for ordinary investors. Venture capital and private
equity funds typically have high net worth thresholds for their
clients.

Furthermore, if one wishes to invest in non-public firms on her
own account, regulators also place income and wealth requirements
on investors. In the US, only those with an annual income in excess
of $200,000, or $1,000,000 in assets, can buy in private offerings.
Similar requirements are in place in the EU.

Declining yields and the dearth of public offerings have
combined to push the market returns available to retail investors
to historic lows. This will make it more difficult for ordinary
people to save for retirement, home purchases and education. In the
meantime, those already with financial means are able put their
funds into promising new ventures. Well-known internet unicorns
such as Airbnb and Uber remain private and thus largely restricted
to “sophisticated” (read: wealthy) investors.

Nor is this problem strictly American. British and other
European investors hold U.S.- listed stocks, so they should also be
concerned about the dearth of new offerings. Moreover, a similar
trend of declining IPOs has lately been apparent in the London
market, too. Finally, because so many of the most transformative
innovations are seeded in America, that capital to fund them is
becoming costlier should concern us all.

Back in the 1980s, it was an explicit aim of policy to turn more
people into shareholders. Bringing capital to the people was, in
the eyes of many, what made capitalism popular. Today, however,
regulation is restricting broadly dispersed asset ownership - and
the long-term consequences may well be felt beyond households’
retirement accounts.